A Hedge Becomes Defence
Central banks and governments, depending upon the division of financial authority in a given nation, will hold significant Foreign Currency Reserves. There are many reasons to hold FX reserves. Firstly, it allows the nation to finance the capital account deficits created by its consumer, business, investment and governmental spending. Aside from facilitating international transactions at the national or common currency level, reserves also act to diversify risk in the domestic system.
To justify why foreign currency reserves have a balancing effect to sources of exogenous risk, let’s consider a nation that holds no reserve. It would be impossible to imagine a nation/government even with very low wealth per capita that would not hold significant sums of domestic currency. When an economic shock hits that country either from domestic activity (or lack thereof) or from an external source, the stockpile of wealth acts to destabilise the overall system. The value of wealth and reserves held in local currency decrease in relative value as the very currency it is held in deteriorates in buying power. This perpetuates the shock adding to its impact on the underlying economy.
When those domestic reserves of wealth become sizeable, it would therefore be sensible for a nation to take out contracts against its own currency or indeed diversify the underlying physical holdings into a foreign currency. When domestic currency reserves are too low in comparison to foreign reserves, instead of printing money, a nation can do the opposite: sell foreign reserves in favour of its own currency. This avoids the inflationary effects of quantitative easing that are very unpalatable for most nations in today’s financial environment. For a net importing nation, such activities can even help to reduce inflationary pressures imported from overseas.
Queue Sweden. A lot of chatter has taken place about the prospect of Sweden’s central bank buying the Krona and selling some of its international reserves. Figures of up to $6bn have been discussed as up for sale within FX forwards in the coming months. This is a timely debate with FX intervention being heavily discussed and driving significant volatility in the Yen last week.
Discussion and Analysis by Charles Porter
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